(June 1, 2001) Anatomy of (Yet Another) Hedge Fund Fraud
Date: Monday, July 13 @ 12:36:18 UTC
Topic: Money Matters
Forget everything you've ever heard or read about hedge
funds. As the media churns out fanciful stories about
wildly successful hedge fund managers that take huge risks
and produce spectacular returns, investor demand grows and
the number of hedge fund operators mushrooms. When
investors think of hedge funds, names like Robertson,
Steinhardt, Druckenmiller and Soros come to mind. These
legendary figures gave hedge funds their sterling
reputation. However, today many hedge fund operators are,
in reality, simply unscrupulous day-traders preying upon
gullible investors with as little as $5,000 to invest.
Unregulated and operating in secrecy, hedge funds are a great place for scam artists. Why continue hustling for commissions selling penny stocks when for the price of having a lawyer draft a believable private placement memorandum, you can call yourself a hedge fund manager? Leave behind any disciplinary problems you may have had as a broker regulated by the National Association of Securities Dealers and, as a money manager unregulated by the SEC charge your clients a hefty so-called "performance fee" far greater than any conventional money manager.
Recently I was called upon to advise the happiest investor I'd met in a long time. A successful entrepreneur who had sold his business, he invested in a hedge fund three years ago that had produced an astounding 50% return annually. Incredible performance, without a doubt. The question I was asked was simple enough: "Given my manager's consistently fantastic performance, shouldn't I invest more in his fund?" With the greatest of reluctance and only after repeated requests, I agreed to review his investment in the fund.
Why was I so reluctant? Hedge funds are perhaps the least understood of investments. The vast amount of misinformation that circulates about these funds is truly daunting. Peeling away the layers of misunderstanding about them is a difficult and thankless task. In a world of bureaucratic money managers with mediocre performance, investors want to believe in the myth of maverick gunslingers who outsmart the market. Unfortunately, as is often the case with sensational investment stories, the results do not stand up to close scrutiny. This is bad news investors do not want to hear.
At the outset let me say that some hedge fund managers are clearly far more credible than others. The largest and oldest hedge funds may be more legitimate than the small hedge fund operator you meet at your local country club. But even the largest hedge funds operate in secrecy and are unregulated. They are free to engage in practices that would land a SEC registered investment adviser in jail. "Front-running" and other personal trading abuses are commonplace. Use of client brokerage commissions to benefit the manager or "soft dollar" abuses are permissible. Unless it's outright fraud, it passes muster. And since there are no disclosure obligations, investors are unlikely to learn about even the most questionable behavior.
It is often said that the best money managers flock to the hedge fund industry-the super-talented, emerging stars with wealthy fans. But an unregulated environment attracts all those who do not want to play by the rules that shackle traditional money managers. Some of these individuals are, no doubt, tremendously talented. However, in my experience, some of the least reputable managers, managers who couldn't make it in a regulated environment, have chosen to open hedge funds. The lack of regulation results in a lack of information critical to determining the capability of the hedge fund manager. Information regarding references, credentials, investment process, performance, ethics, and financial solvency can all be manipulated.
As a result, published data regarding the hedge fund industry can be misleading. Anyone who claims to be able to provide comprehensive information about this industry should be questioned. Unless their universe includes the poor performers and fringe players, the analysis is incomplete. Data regarding only the best funds of the most successful managers for the best years in their histories is meaningless.
Let's get back to my satisfied hedge fund investor and the analysis I undertook on his behalf.
A cursory review of the private offering memorandum of the hedge fund in which he invested revealed a marginally adequate document. It had not been drafted by an attorney skilled in investment management matters. The investment objective and business of the partnership were particularly poorly defined. "Superior returns consistent with the risks inherent in its activities," seemed absurdly brief and vague. The fund could invest in everything: municipal bonds, equities, preferred stocks, futures, options and options on futures. Essentially the investor had given his money to the manager without any clear understanding as to how it would be invested.
There was a time when the term "hedge fund" referred to an investment strategy. Typically it meant short selling to profit from market downturns. Today "hedge fund" simply refers to how the manager is compensated. Hedge funds don't necessarily hedge. These are funds as to which the manager gets paid a hefty 20% of the profits for managing the assets in a non-traditional manner, i.e., substantially higher than average portfolio turnover coupled with the use of leverage. The money may be invested in any asset class, sector or market worldwide.
A common belief is that hedge funds are for sophisticated, wealthy investors. The minimum investment for these funds used to be $1 million or more. Today investors with as little as $100,000 who participate in pooling programs at brokerages can get into hedge funds and the minimum can be as low as $10,000 for hedge funds structured more like mutual funds. Well, my investor's fund had a $5,000 minimum, which could be waived by the General Partner. Hedge funds have gone retail, I discovered. They are finally available to anyone yearning for stellar returns. "You don't have to be rich to get in on the action," read the cover of a recent edition of BusinessWeek.
At this point my concerns were mounting and about to explode. A check of the manager's impressive Wall Street client references revealed that the individuals named at each firm were brokers who had simply executed trades on behalf of the fund. The Wall Street firms had never invested in the fund.
The manager indicated in the offering memorandum that it was a registered investment advisor. A search of the appropriate records indicated the firm was not registered. The investors' funds were supposedly being held at a "major money center" but my client had never been told where that might be. My client was receiving monthly unaudited performance reports prepared by the adviser, however, the annual audited financial statements the adviser had committed to furnishing in the offering document had not been produced in the past three years. When asked, the adviser said he had determined it would be in the investors' best interest to save the cost of an annual audit.
The investors in the hedge fund partnership had received K-1 forms annually indicating each investor's share of the partnership's income. I thought it odd that a small certified public accountant on the other side of the country was preparing these forms. The size of the accounting firm disturbed me less than its geographic remoteness. Often smaller firms do better work. But surely there were some competent accountants locally.
Investors frequently make the mistake of believing the retention of a major accounting firm or law firm by a hedge fund somehow guarantees or suggests that everything is on the up and up. It is na´ve to believe that accounting or law firms are selective in representing clients. Generally, if the client will pay their inflated fees, these large firms will gratefully take the assignment. Indeed, the most successful scam artists regularly outsmart their outside experts or even use the skills and reputation of these experts to perpetuate the fraud. The presence of a highly regarded accounting or law firm is a factor worth considering but undue reliance should not be placed upon their involvement.
My client had been dutifully paying the tax obligation related to his impressive gains out of his pocket. (He didn't want to remove any money from the wonderfully performing hedge fund.) By this point, it was clear my client had nothing to substantiate his investment gains. He didn't know where the money was, how it was invested or the current value of his account. Indeed, he was paying additional money to the IRS on money that he might have already lost.
As my fact-finding continued, additional information came to light about the manager's personal financial condition that was extremely disturbing. Within days of commencement of my inquiry, I recommended that the client ask for all of his money back immediately, in light of the likelihood of fraud.
Hedge fund documents limit investors' redemption rights. Depending upon the provisions of the partnership agreement, the investor may have to wait an extended period of time, perhaps a year, for his money. This can be especially disconcerting when the investor has reason to believe wrongdoing may be involved. The investor must struggle with the question of whether he will be jeopardizing his investment by blowing the whistle on the manager. Or is his money already gone?
Generally in these cases the manager will try to delay the inevitable once he is approached by law enforcement or regulatory agencies. Records related to client accounts will be hard to locate for one reason or another. Explanations and excuses will be proffered. Lawyers will be retained by the manager as he begins to realize he can't talk his way out of the dilemma.
As of this date, it appears my client will never see his original investment even, much less the astronomical gains he supposedly earned. He should be able to recover the taxes he paid on the apparently fraudulent gains.
Investors want to believe hedge funds hold the promise of fabulous returns. So much so that they generally fail to investigate before they invest. It has been estimated that perhaps 15% to 20% of hedge fund managers may engage in fraudulent activity. But hedge operators are simply today's most fashionable investment managers.
My experience is that the money management industry, including brokers and financial planners, generally experiences a 5%-10% fraud rate. When you consider how many lives are ruined by unscrupulous managers, planners, private bankers and brokers who rob investors of their savings, you have to wonder why so little attention is paid to the issue. Isolated cases are reported as if, in each instance, they were unprecedented and the full extent of the problem is never revealed. The financial services industry would have you believe these cases are a rarity. But if even 5% of the money invested globally is subject to fraud, that would make fraud a highly lucrative, multi-trillion dollar business where hardly anyone ever goes to jail.
This article comes from Pension fraud Investigations, money management abuse
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